The Risk-Reward Fallacy

What if Risk and Reward are not related the way you think?

It is a near-sacred assumption in the theory of valuation of financial assets that people will only accept risk if they expect to be paid for doing so.  That might even be true, and if one looks at the history of the stock and bond markets it can seem a convincing proposition.

Persuasive, and necessarily true, though are not the same thing.  People should pay attention to that.  There is the informal logic flaw called “The Historian’s Fallacy.”  The Historian’s Fallacy arises because people who come along later often make the implicit assumption that the decision maker at some past time knew the same things that they now know.  We can all agree that that assumption is absurd.  They knew what they knew and no more.

Some time ago, I wrote an article titled, “Are You Smart Enough To Know The Future?”  It dealt with decision making and in particular Ron Wayne’s decision to sell his 10% interest in Apple Inc for less than $2,500.  I argued that, in his position at that time, it was a good decision.  As it turned out, possibly not excellent.

Ron Wayne did not know the future and therefore could not act upon it.  We know the past and can easily say it was a weak decision.

You will live in the future not the past.  You use the past to help you make decisions, but you know only some of the past and it may be not be appropriate.  The part you know may have been conditioned by “Experts.”  Consider the flaw, “Argument from Authority.”  Experts occasionally err and you should be aware of that.

Your reality is that you do not know and cannot reliably predict the future.  The future is the risk, not the investment.

The problem gets worse as we dig deeper.

  1. Market risk, based on historic details, can be known.  What is not known in those, is whether or not the future will bear any resemblance to the past.  Just like in mathematical linear regression analysis, events outside the observed data cannot be reliably estimated.
  2. Events that did not happen are unrecorded.  Absence of evidence is not evidence of absence.  Another flaw.  In physics, Erwin Schrodinger has postulated that unless an event is specifically prohibited, it will eventually occur.  It is difficult to make a list of all that has not yet happened or even that which did happen, but which history has ignored.  Market data has a profound survivor basis and some important information is missing.
  3. Mathematically, risk is a function of two factors.  The probability of the outcome and the magnitude of the gain or loss.  That is assumed in all of the analysis.  But, your personal risk is not the same thing.  If you take the mathematical risk and add in the effect on you if the risk appears, all sorts of different answers may appear.  How bad can things be before I cannot tolerate the outcome?  Is that level of loss possible? That is your risk capacity.

You need to consider your capacity limit.  No individual has personal risk equal to average risk in the market over a long time.   Simple – it does not matter what long run average risk may be if you don’t survive the short run.

If the average depth of water in a river is four feet, you should not assume you can wade across it without drowning.

Same thing for the stock market.

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Don Shaughnessy is a retired partner in an international public accounting firm and is now with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

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